IGNOU : M.COM : MCO 7 : UNIT 5 : Q - 2. How will you calculate the Cost of Preferences Share Capital ?

Ans. Cost of Preference Capital

The preference share represents a special type of ownership interest in the firm. Preference shareholders must receive their stated dividends prior to the distribution of any earnings to the equity shareholders. In this respect preference shares are very much like bonds or debentures with fixed interest payment. The cost of preference shares can be estimated by dividing the preference dividend per share by the current price per share, as the dividend can be considered a continuous  level payment.                                                                  

Cost of Preference Capital        =      Dividend/   Market Price – Issue Cost

For example, A company is planning to issue 9% preference shares expected to sell at Rs. 85 per share. The costs of issuing and selling the shares are expected to be Rs. 3 per share.

The first step in finding out the cost of the preference capital is to determine the rupee amount of preference dividends, which are stated as 9% of the share of Rs. 85 per share. Thus 9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs, the net proceeds are Rs. 82 per share.

Thus the cost of preference capital :

=  Dividend per share/ Net proceeds after selling

=   Rs. 7.65 /Rs. 82 = 9.33 %

Now, the companies can issue only redeemable preference shares. Cost of capital for such shares is that discount rate which equates the funds available from the issue of preference shares with the present values of all dividends and repayment of preference share capital. This present value method for cost of preference share capital is similar to that used for cost of debt capital, the only difference is that in place of `interest’ stated dividend on preference share is used.